A central bank, reserve bank or monetary authority, is an entity responsible for the monetary policy of its country or of a group of member states. Its primary responsibility is to maintain the stability of the national currency and money supply, but more active duties include controlling loan interest rates, and acting as a "bailout" lender of last resort to the banking sector during times of financial crisis.

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It may also have supervisory powers, to ensure that banks and other financial institutions do not behave recklessly or fraudulently.

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In most countries the central bank is state owned and has a minimal degree of autonomy, which allows for the possibility of government intervening in monetary policy. An "independent central bank" is one which operates under rules designed to prevent political interference examples include the European Central Bank, and the Federal Reserve.

Unless it has only a single goal, the central bank is forced to strike a balance among competing objectives

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Difficulties for deriving an optimal policy rule

Defining the objective function

Weights of these objectives,

Central banks must in a figurative, not literal sense create their own social welfare function based on their legal mandate, their own value judgment and perhaps their reading of the political will. (Alan S. Blinder-Former Deputy Chairman of FED)

8Difficulties for deriving an optimal policy rule

Macro Model Uncertainty Monetary policy making requires more than just qualitative information that theory provides

Economies change over time

Exogenous factors

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Lags in policy implementation

Monetary policy operates on an economy with long and variable lags.

Monetary policy horizon estimate for

UK 8 quarters, Turkey 6 quarters.

Monetary policy decision must be thought of as a first step along a path

10Different interpretations for the utility function

At a time when the price level is rising and employment is relatively full, price stability takes precedence over full employment as a policy objective. At a time when prices are stable and unemployment is rising, on the other hand employment becomes the prime objective.

Charles E. Whittlesey (1970)

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The country specific factors, the economic conditions, the status of the Central Banks as well as many other factor determine the process of prioritizing goals.

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The main goal of monetary policy for most central banks is to maintain the internal and external value of the domestic currency. In the domestic economy this means to keep inflation low and steady. In order to achieve the goal, the authorities need to decide on targets against which the implementation of monetary policy can be assessed and the monetary policy instruments used to achieve the target(s).

13Impossible Trinity

In a fully liberalised system, including full convertibility on the external current and capital accounts, the central bank cannot for very long maintain both an independent domestic monetary policy - whether on interest rates or the money supply - and the exchange rate. If it has an independent target for interest rates, for example, it will have to accept the market-determined exchange rate. If, on the other hand, it targets the

exchange rate it will have to accept the interest rates (and quantity of domestic money) necessary to keep the exchange rate stable.

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The point is that you can't have it all A country must pick two out of three. It can fix its exchange rate without emasculating its central bank, but only by maintaining controls on capital flows (like China -1999) it can leave capital movement free but retain monetary autonomy, but only by letting the exchange rate fluctuate (like Britain--or Canada) or it can choose to leave capital free and stabilize the currency, but only by abandoning any ability to adjust interest rates to fight inflation or recession (like Argentina -1999)."

Paul Krugman(1999)

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Monetary operations refer to the implementation of monetary policy.Under this broad umbrella, the monetary authorities need to decide which specific targets to aim at, and which policy instruments should be used. For most countries the final long-term monetary target of the central bank is low and stable inflation. For operational purposes, however, the day-today target is usually to achieve a particular level of interest rates, commercial banks reserves or the exchange rate.

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In market economies it is widely held that in the long run the most efficient instruments of monetary policy are those which best complement

the workings of a market system. This is why indirect and market-based instruments are preferred to administrative controls. The latter may work for a while, but tend to distort markets and are open to evasion.

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The main monetary policy instruments available to central banks are

open market operation,

bank reserve requirement,

interest-rate policy,

re-lending and re-discount (including using the term repurchase market),

A point close to the center of the chart indicates little or no involvement

At the edge full involvement

Note issuance is at the center

22Functions of the Central Bank

In general a look at a specific central banks balance sheet indicates the functions of that particular central bank. The following ten accounts, five asset and five liabilities account, typically appear on the balance sheet of a central bank.

23Liabilities

Notes payable

Deposits of banks

Treasury deposits

Foreign deposits

Deferred availability items

24Assets

Gold

Loans to banks

Government Securities

Foreign Securities

Items being collected

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Notes payable Central banks issue currency.

Deposits of banks Central banks play the role of banker to commercial banks. Commercial banks use central bank in a manner analogous to the way that a citizen uses a local bank.

Treasury deposits Central banks play the role of banker to governments.

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Foreign deposits Central banks play banker for other central banks and other official or authorized institutions of foreign governments.

Gold Central banks hold gold as a safe asset class and for long term investment.

Loans to banks Central banks make loans to commercial banks.

Government Securities Central banks hold government securities whether issued by the Treasury or other federal agencies. Sometimes central banks will hold securities of private corporations or perhaps even shares of stock traded on exchanges.

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Foreign Securities Central banks hold foreign exchange in the form of securities denominated in the currency of other currencies.

By watching changes in each of the balance sheet items,one can interpret the actions taken by managers of central banks and discern the role that a central bank plays in the economy. The role played by central banks is not so evident in the balance sheet items.

29Federal Reserve System

Conducting the nations monetary policy by influencing the monetary and credit conditions in the economy in pursuit of maximum employment, stable prices and moderate long term interest rates

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Supervising and regulating banking institutions to ensure the safety and soundness of the nations banking and financial system and to protect the credit rights of consumers.

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Maintaining the stability of the financial system and containing systemic risks that may arise in financial markets.

Providing financial services to depository institutions, the US government, and foreign official institutions, including playing a major role in operating the nations payment systems.

32The European System of Central Bank

The primary objective of the ESCB is to maintain price stability. Without prejudice to this goal, the ESCB also aims to support the general economic policies in the Community with a view to contributing the achievement of the objectives of the objectives of the Community as laid down in Article 2, which include high level of employment and sustainable , non-inflationary growth.

33Central Bank Goals 34CENTRAL BANK OF TURKEY

The primary objective of the Bank is to achieve and maintain price stability. Provided that it is not be in confliction with the primary objective, The Bank shall support the growth and employment policies of the Government.

35(No Transcript) 36Basic Data on Central Banks 37

In Europe prior to the 17th century most money was commodity money, typically gold or silver. However, promises to pay were widely circulated and accepted as value at least five hundred years earlier in both Europe and Asia. The medieval European Knights Templar ran probably the best known early prototype of a central banking system, as their promises to pay were widely regarded, and many regard their activities as having laid the basis for the modern banking system. At about the same time, Kublai Khan introduced fiat currency to China, which was imposed by force by the confiscation of specie.

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The oldest central bank in the world is the Riksbank in Sweden, which was opened in 1668 with help from Dutch businessmen. This was followed in 1694 by the Bank of England, created by Scottish businessman William Paterson in the City of London at the request of the English government to help pay for a war. The Bulgarian National Bank was established on 25 January 1879. The US Federal Reserve was created by the U.S. Congress through the passing of the Glass-Owen Bill, signed by President Woodrow Wilson on December 23, 1913.

39Number of Central Banks 40(No Transcript) 41How many Central Bankers?(2005) 42Central Bankers Salaries (000) 43Guiding Principles for Central Banks 1. Price stability provides substantial benefits2. Fiscal policy should be aligned with monetary policy3. Time inconsistency is a serious problem to be avoided4. Monetary policy should be forward looking5. Accountability is a basic principle of democracy6. Monetary policy should be concerned about output as well as price fluctuations7. The most serious economic downturns are associated with financial instabilitySource Mishkin, 2000 44(No Transcript)